**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

 

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarter ended October 31, 2003 OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                 to                 **

 

**Commission file number 000-22009**

 

 

**NEOMAGICCORPORATION**

**(Exactname of Registrant as specified in its charter)**

 

| **DELAWARE**                                                    |   | **77-0344424**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| [State or other jurisdiction  of incorporation or organization] |   | [I.R.S. Employer Identification No.] |
|                                                            |   |                                 |
| **3250 Jay Street  Santa Clara, California**                    |   | **95054**                            |
| [Address of principal executive offices]                        |   | [Zip Code]                           |

 

**(408) 988-7020**

Registrant’s telephone number, including areacode

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15 (d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes    ý    No    o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the ExchangeAct)   Yes    o    No    ý

 

The number of shares of the Registrant’s Common Stock, $.001 par value,outstanding at October 31, 2003 was 31,429,036

 

 

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NEOMAGIC CORPORATION

FORM 10-Q

 

**INDEX**

 
| PART I.   CONSOLIDATED CONDENSED FINANCIAL INFORMATION         |                                                                                                    |
|---------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                                |                                                                                                    |   |
| Item 1.                                                             | Unaudited Consolidated Condensed Financial  Statements:                                                 |   |
|                                                                |                                                                                                    |   |
|                                                                | Consolidated  Condensed Statements of Operations  Three and Nine months ended October 31, 2003 and 2002 |   |
|                                                                |                                                                                                    |   |
|                                                                | Consolidated Condensed  Balance Sheets  October 31, 2003 and January 31, 2003                           |   |
|                                                                |                                                                                                    |   |
|                                                                | Consolidated  Condensed Statements of Cash Flows  Nine months ended October 31, 2003 and 2002           |   |
|                                                                |                                                                                                    |   |
|                                                                | Notes to  Unaudited Consolidated Condensed Financial Statements                                         |   |
|                                                                |                                                                                                    |   |
| Item 2.                                                             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations             |   |
|                                                                |                                                                                                    |   |
| Item 3.                                                             | Quantitative and Qualitative Disclosures about  Market Risk                                             |   |
|                                                                |                                                                                                    |   |
| Item 4.                                                             | Controls and Procedures                                                                                 |   |
|                                                                |                                                                                                    |   |
| PART II.   OTHER INFORMATION                                   |                                                                                                    |
|                                                                |                                                                                                    |   |
| Item  1.  Legal Proceedings                                    |                                                                                                    |
|                                                                |                                                                                                    |   |
| Item  2.  Changes in Securities                                |                                                                                                    |
|                                                                |                                                                                                    |   |
| Item  3.  Defaults Upon Senior Securities                      |                                                                                                    |
|                                                                |                                                                                                    |   |
| Item  4.  Submission of Matters to a Vote of  Security Holders |                                                                                                    |
|                                                                |                                                                                                    |
| Item  5.  Other Information                                    |                                                                                                    |
|                                                                |                                                                                                    |
| Item  6.  Exhibits and Reports on Form 8-K                     |                                                                                                    |
|                                                                |                                                                                                    |
| Signatures                                                          |                                                                                                    |

 

2

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Part I.  Financial Information

Item 1.  Financial Statements

 

**NEOMAGIC CORPORATION**

**CONSOLIDATEDCONDENSED STATEMENTS OF OPERATIONS**

(In thousands,except per share data)

(Unaudited)

 
|                                                                                    |   | **Three  Months Ended** |   | **Nine  Months Ended** |   |
|-----------------------------------------------------------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                                                                    |   | **October  31,  2003**  |   | **October  31,  2002** |   | **October  31,  2003** |   | **October  31,  2002** |   |
| Net sales                                                                               |   | $                       | 486    |                   | $      | 655 |   | $ | 1,332 |   | $ | 1,511 |   |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Cost of product sales (1)                                                               |   | 623                     |   | 780                    |   | 1,630 |   | 2,085 |   |
| Impairment of certain acquired intangible  assets                                       |   | —                  |   | 367                    |   | — |   | 367 |   |
| Total                                                                                   |   | 623                     |   | 1,147                  |   | 1,630 |   | 2,452 |   |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Gross loss                                                                              |   | (137                    | )      | (492                   | )      | (298 | ) | (941 | ) |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Operating expenses:                                                                     |   |                    |   |                   |   |   |   |   |   |
| Research and development (2)                                                            |   | 5,340                   |   | 5,662                  |   | 14,849 |   | 18,131 |   |
| Sales, general and administrative (3)                                                   |   | 1,835                   |   | 2,127                  |   | 5,379 |   | 7,836 |   |
| Impairment of certain acquired intangible  assets                                       |   | —                  |   | 506                    |   | — |   | 506 |   |
| Special Charges                                                                         |   | —                  |   | —                 |   | — |   | 3,600 |   |
| Total operating expenses                                                                |   | 7,175                   |   | 8,295                  |   | 20,228 |   | 30,073 |   |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Loss from operations                                                                    |   | (7,312                  | )      | (8,787                 | )      | (20,526 | ) | (31,014 | ) |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Other income (expense), net:                                                            |   |                    |   |                   |   |   |   |   |   |
| Income from the sale of DVD assets                                                      |   | —                  |   | —                 |   | — |   | 1,580 |   |
| Interest income                                                                         |   | 148                     |   | 300                    |   | 570 |   | 1,325 |   |
| Other income (expense)                                                                  |   | 215                     |   | (23                    | )      | 172 |   | 232 |   |
| Interest expense                                                                        |   | (66                     | )      | —                 |   | (226 | ) | — |   |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Loss before income tax benefit and  cumulative effect of change in accounting principle |   | (7,015                  | )      | (8,510                 | )      | (20,010 | ) | (27,877 | ) |
| Income tax expense (benefit)                                                            |   | 33                      |   | —                 |   | 39 |   | (6,339 | ) |
| Loss before cumulative effect of change in  accounting principle                        |   | (7,048                  | )      | (8,510                 | )      | (20,049 | ) | (21,538 | ) |
| Cumulative effect of change in accounting  principle                                    |   | —                  |   | (4,175                 | )      | — |   | (4,175 | ) |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Net loss                                                                                |   | $                       | (7,048 | )                      | $      | (12,685 | ) | $ | (20,049 | ) | $ | (25,713 | ) |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Basic and diluted net loss per share                                                    |   | $                       | (0.23  | )                      | $      | (0.44 | ) | $ | (0.66 | ) | $ | (0.90 | ) |
|                                                                                    |   |                    |   |                   |   |   |   |   |   |
| Weighted average common shares outstanding  for basic and diluted                       |   | 30,759                  |   | 29,157                 |   | 30,498 |   | 28,453 |   |

 

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(1)                                  Includes $11 and $0in amortization of deferred stock compensation for the three months endedOctober 31, 2003 and 2002, respectively, and $26 and $0 for the nine monthsended October 31, 2003 and 2002, respectively

 

(2)                                  Includes $128 and$101 in amortization of deferred stock compensation for the three months endedOctober 31, 2003 and 2002, respectively, and $285 and $863 for the nine monthsended October 31, 2003 and 2002, respectively.

 

3

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(3)                                  Includes$104 and $143 in amortization of deferred stock compensation for the threemonths ended October 31, 2003 and 2002, respectively, and $191 and $906  for the nine months ended October 31, 2003and 2002, respectively. 

 

Seeaccompanying notes to consolidated condensed financial statements.

 

4

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**NEOMAGIC CORPORATIONCONSOLIDATED CONDENSED BALANCE SHEETS**(In thousands)

 
|                                            |   | **October  31,  2003** |   | **January  31,  2003 (1)** |   |
|-------------------------------------------------|--------|------------------------|--------|----------------------------|--------|
|                                            |   | **(Unaudited)**        |   |                       |   |
| **ASSETS**                                      |   |                   |   |                       |   |
| Current assets:                                 |   |                   |   |                       |   |
| Cash and cash equivalents                       |   | $                      | 9,641  |                       | $      | 37,428 |   |
| Short-term investments                          |   | 38,910                 |   | 29,657                     |   |
| Accounts receivable, net                        |   | 197                    |   | 118                        |   |
| Inventory                                       |   | 284                    |   | 535                        |   |
| Employee note receivable                        |   | —                 |   | 1,200                      |   |
| Other current assets                            |   | 932                    |   | 1,210                      |   |
| Total current assets                            |   | 49,964                 |   | 70,148                     |   |
|                                            |   |                   |   |                       |   |
| Property, plant and equipment, net              |   | 4,170                  |   | 5,840                      |   |
| Employee notes receivable                       |   | 32                     |   | 100                        |   |
| Intangibles, net                                |   | 3,591                  |   | 4,349                      |   |
| Other assets                                    |   | 382                    |   | 511                        |   |
|                                            |   |                   |   |                       |   |
| Total assets                                    |   | $                      | 58,139 |                       | $      | 80,948 |   |
|                                            |   |                   |   |                       |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**   |   |                   |   |                       |   |
| Current liabilities:                            |   |                   |   |                       |   |
| Accounts payable                                |   | $                      | 1,908  |                       | $      | 2,864 |   |
| Compensation and related benefits               |   | 1,433                  |   | 1,393                      |   |
| Income taxes payable                            |   | 3,675                  |   | 3,633                      |   |
| Current portion of capital lease  obligations   |   | 1,475                  |   | 1,363                      |   |
| Other accruals                                  |   | 319                    |   | 1,287                      |   |
| Total current liabilities                       |   | 8,810                  |   | 10,540                     |   |
|                                            |   |                   |   |                       |   |
| Capital lease obligations                       |   | 1,603                  |   | 2,521                      |   |
|                                            |   |                   |   |                       |   |
| Commitments and contingencies                   |   |                   |   |                       |   |
|                                            |   |                   |   |                       |   |
| Stockholders’ equity:                      |   |                   |   |                       |   |
| Common stock                                    |   | 31                     |   | 30                         |   |
| Additional paid-in-capital                      |   | 89,373                 |   | 89,237                     |   |
| Deferred compensation                           |   | (220                   | )      | (4                         | )      |
| Accumulated other comprehensive income  (loss)  |   | (24                    | )      | 9                          |   |
| Accumulated deficit                             |   | (41,434                | )      | (21,385                    | )      |
| Total stockholders’ equity                 |   | 47,726                 |   | 67,887                     |   |
|                                            |   |                   |   |                       |   |
| Total liabilities and stockholders’ equity |   | $                      | 58,139 |                       | $      | 80,948 |   |

 

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(1)                                  Derived from theJanuary 31, 2003 audited consolidated financial statements included in theAnnual Report on Form 10-K of NeoMagic Corporation for fiscal year 2003.

 

Seeaccompanying notes to consolidated condensed financial statements.

 

5

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**NEOMAGIC CORPORATIONCONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS**(In thousands)

(Unaudited)

 
|                                                                                     |   | **Nine  Months Ended** |       |
|------------------------------------------------------------------------------------------|--------|------------------------|------------|
|                                                                                     |   | **October  31,  2003** |       | **October  31,  2002** |   |
| **Operating activities:**                                                                |   |                   | ** ** |   | ** ** |
| Net loss                                                                                 |   | $                      | (20,049    | ) | $ | (25,713 | ) |
| Adjustments to reconcile net loss to net  cash used for operating activities:            |   |                   |       |   |   |
| Depreciation and amortization                                                            |   | 2,850                  |       | 2,206 |   |
| Loss on disposal of property, plant and  equipment                                       |   | 3                      |       | 2 |   |
| Loss on restructuring of wafer purchase agreement                                        |   | —                 |       | 3,600 |   |
| Income from the sale of DVD assets                                                       |   | —                 |       | (1,580 | ) |
| Amortization of deferred compensation                                                    |   | 502                    |       | 1,771 |   |
| Impairment of acquired intangible assets  and goodwill                                   |   | —                 |       | 5,048 |   |
| Changes in operating assets and  liabilities:                                            |   |                   |       |   |   |
| Accounts receivable                                                                      |   | 35                     |       | (310 | ) |
| Inventory                                                                                |   | 251                    |       | (648 | ) |
| Income tax receivable                                                                    |   | —                 |       | 3,295 |   |
| Other current assets                                                                     |   | 406                    |       | (187 | ) |
| Restricted cash                                                                          |   | —                 |       | 15,000 |   |
| Other assets                                                                             |   | 69                     |       | (457 | ) |
| Accounts payable                                                                         |   | (956                   | )          | 22 |   |
| Compensation and related benefits                                                        |   | 40                     |       | 194 |   |
| Income taxes payable                                                                     |   | 42                     |       | (412 | ) |
| Tax benefit from employee stock options                                                  |   | 355                    |       | — |   |
| Other accruals                                                                           |   | (1,082                 | )          | (807 | ) |
| Net cash provided by (used in) operating  activities                                     |   | (17,534                | )          | 1, 024 |   |
|                                                                                     |   |                   |       |   |   |
| **Investing activities:**                                                                |   |                   | ** ** |   | ** ** |
| Net proceeds from the sale of DVD assets                                                 |   | —                 |       | 1,580 |   |
| Purchases of property, plant, equipment and  intangibles                                 |   | (425                   | )          | (702 | ) |
| Purchases of short-term investments                                                      |   | (52,357                | )          | (41,191 | ) |
| Maturities of short-term investments                                                     |   | 43,071                 |       | 44,713 |   |
| Net cash provided by (used in) investing  activities                                     |   | (9,711                 | )          | 4,400 |   |
|                                                                                     |   |                   |       |   |   |
| **Financing activities:**                                                                |   |                   | ** ** |   | ** ** |
| Payments on capital lease obligations                                                    |   | (806                   | )          | — |   |
| Net proceeds from issuance of common stock                                               |   | 264                    |       | 492 |   |
| Net cash provided by (used in) financing  activities                                     |   | (542                   | )          | 492 |   |
|                                                                                     |   |                   |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                    |   | (27,787                | )          | 5,916 |   |
| Cash and cash equivalents at beginning of  period                                        |   | 37,428                 |       | 38,996 |   |
| Cash and cash equivalents at end of period                                               |   | $                      | 9,641      |   | $ | 44,912 |   |
|                                                                                     |   |                   |       |   |   |
| Supplemental schedules of cash flow information:                                         |   |                   |       |   |   |
| Cash paid (received) during the period for:                                              |   |                   |       |   |   |
| Interest                                                                                 |   | $                      | 152        |   | $ | — |   |
| Taxes                                                                                    |   | $                      | 55         |   | $ | (9,568 | ) |
| Supplemental disclosure of non-cash  financing activities:                               |   |                   |       |   |   |
| Issuance of common stock in connection with  restructuring of wafer purchasing agreement |   | $                      | —     |   | $ | 2,100 |   |

 

See accompanying notes to consolidatedcondensed financial statements. 

 

6

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**NEOMAGICCORPORATION**

**NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS**

 

**1.     Basisof Presentation**

 

The unaudited consolidated condensed financialstatements have been prepared pursuant to the rules and regulations of theSecurities and Exchange Commission and include the accounts of NeoMagicCorporation and its wholly owned subsidiaries (collectively “NeoMagic” or the“Company”).  Certain information andNote disclosures, normally included in financial statements prepared inaccordance with generally accepted accounting principles, have been condensedor omitted pursuant to such rules and regulations.  In the opinion of the Company, the financial statements reflectall adjustments, consisting only of normal recurring adjustments, necessary fora fair presentation of the financial position at October 31, 2003, theoperating results for the three and nine months ended October 31, 2003 and2002, and the cash flows for the nine months ended October 31, 2003 and2002.  These financial statements andnotes should be read in conjunction with the Company’s audited financialstatements and notes thereto for the year ended January 31, 2003, included inthe Company’s most recent Form 10-K filed with the Securities and ExchangeCommission.

 

The results of operations for the three and nine months ended October31, 2003 are not necessarily indicative of the results that may be expected forthe year ending January 31, 2004.

 

Thethird fiscal quarters of 2003 and 2002 ended on October 26, 2003 and October27, 2002, respectively.  For ease ofpresentation, the accompanying financial statements have been shown as endingon the last day of the calendar month of October.

 

**2.     RecentAccounting Pronouncements**

 

In November of 2002, the EITF reached aconsensus on Issue No.  00-21, “RevenueArrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidanceon how to account for arrangements that involve the delivery or performance ofmultiple products, services and/or rights to use assets.  The provisions of EITF Issue No. 00-21 applyto revenue arrangements entered into in fiscal periods beginning after June 15,2003.  The adoption of EITF Issue No.00-21 did not have a material effect on the Company’s financial position orresults of operations.

 

In January of 2003, theFASB issued FIN No. 46,  “Consolidationof Variable Interest Entities.” FIN No. 46 requires a variable interest entityto be consolidated by a company if that company is subject to a majority of therisk of loss from the variable interest entity’s activities or entitled toreceive a majority of the entity’s residual returns or both. The consolidationrequirements of FIN No. 46 apply immediately to variable interest entitiescreated after January 31, 2003. The consolidation requirements apply to olderentities in the first fiscal year or interim period beginning after December15, 2003. The Company believes the adoption of FIN No. 46 will not have amaterial effect on the Company’s financial position or results of operations.

 

In April 2003, the FASBissued Statement of Financial Accounting Standards No. 149, “Amendment ofStatement 133 on Derivative Instruments and Hedging Activities” which amendsand clarifies accounting for derivative instruments and hedging activitiesunder SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities” (SFAS 149).  SFAS 149provides guidance relating to decisions made (a) as part of the DerivativesImplementation Group process, (b) in connection with other FASB projectsdealing with financial instruments and (c) regarding implementation issuesraised in the application of the definition of a derivative and thecharacteristics of a derivative that contains financing components.  SFAS 149 is effective for contracts enteredinto or modified and for hedging relationships designated after June 30, 2003.  The adoption of SFAS 149 did not have amaterial impact on the Company’s financial condition or results of operations.

 

7

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In May 2003, the FASBissued SFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity” (SFAS 150) which requiresfreestanding financial instruments such as mandatorily redeemable shares,forward purchase contracts and written put options to be reported asliabilities by their issuers as well as related new disclosure requirements.  The provisions of SFAS 150 are effective forinstruments entered into or modified after May 31, 2003 and pre-existinginstruments as of the beginning of the first interim period that commencesafter June 15, 2003.  The adoption ofSFAS 150 did not have a material impact on the Company’s financial condition orresults of operations.

 

**3.     StockCompensation**

 

During the first quarter of fiscal 2004, the Companyadopted the provisions of the FASB issued Statement of Financial AccountingStandards No. 148, “Accounting for Stock-Based Compensation – Transition andDisclosure” (SFAS 148).  SFAS 148 amendsFASB Statement No. 123, “Accounting for Stock-Based Compensation,” to providealternative methods of transition to the fair value method of accounting forstock-based employee compensation.  Inaddition, SFAS 148 amends the disclosure provisions of Statement 123 to requiredisclosure in the summary of significant accounting policies of the effects ofan entity’s accounting policy with respect to stock-based employee compensationon reported net income and earnings per share in annual and interim financialstatements.

 

At October 31, 2003, the Company had severalstock-based employee compensation plans, including stock option plans and anemployee stock purchase plan. The Company accounts for these plans under theintrinsic value method. The following table illustrates the effect on net lossand earnings per share if the Company had applied the fair value recognitionmethod:

 
|                                                                                                                             |   | **Three  Months Ended  October 31,** |   | **Nine  Months Ended  October 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
| **(in thousands, except per share  amounts)**                                                                                    |   | **2003**                             |   | **2002**                            |   | **2003** |   | **2002** |   |
| Net loss, as reported                                                                                                            |   | $                                    | (7,048 | )                                   | $      | (12,685 | ) | $ | (20,049 | ) | $ | (25,713 | ) |
| Add:  Stock-based employee compensation expense included in reported net loss, net  of related tax effects                       |   | 202                                  |   | 244                                 |   | 461 |   | 1,769 |   |
| Less:  Total stock-based compensation expense determined under the fair value method  for all awards, net of related tax effects |   | (870                                 | )      | (1,284                              | )      | (2,381 | ) | (4,496 | ) |
| Pro forma net loss                                                                                                               |   | $                                    | (7,716 | )                                   | $      | (13,725 | ) | $ | (21,969 | ) | $ | (28,440 | ) |
| Reported basic and diluted loss per share                                                                                        |   | $                                    | (0.23  | )                                   | $      | (0.44 | ) | $ | (0.66 | ) | $ | (0.90 | ) |
| Pro forma basic and diluted loss per share                                                                                       |   | $                                    | (0.25  | )                                   | $      | (0.47 | ) | $ | (0.72 | ) | $ | (1.00 | ) |

 

In the three and nine months ended October 31, 2003 and 2002, respectively,the fair value of each option grant was estimated on the date of the grantusing the Black-Scholes option-pricing model using a dividend yield of 0% andthe following additional weighted-average assumptions:

 
|                             |   | **Option Plans**                   |   | **Stock Purchase Plan**            |   |
|----------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                             |   | **Three Month Ended  October 31,** |   | **Nine Months Ended  October 31,** |   | **Three Months Ended  October 31,** |   | **Nine Months Ended  October 31,** |   |
|                             |   | **2003**                           |   | **2002**                           |   | **2003** |   | **2002** |   | **2003** |   | **2002** |   | **2003** |   | **2002** |   |
| Risk-free interest rates         |   | 2.7                                | %      | 2.95                               | %      | 1.99 | % | 3.64 | % | 1.1 | % | 2.2 | % | 1.3 | % | 2.2 | % |
| Volatility                       |   | 0.93                               |   | 0.74                               |   | 0.67 |   | 0.64 |   | 0.97 |   | 0.68 |   | 0.81 |   | 0.71 |   |
| Expected life of option in years |   | 4.28                               |   | 5.0                                |   | 2.80 |   | 4.30 |   | 0.51 |   | 0.49 |   | 0.50 |   | 0.49 |   |

 

8

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The Black-Scholes option valuation model was developedfor use in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility.  Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of its employee stock options.

 

**4.     LossPer Share**

 

Thefollowing data show the amounts used in computing loss per share and the effecton the weighted-average number of shares of diluted potential common stock.

 

Per share information calculated on this basis is as follows:

 
|                                                                                    |   | **Three Months Ended  October 31,** |   | **Nine Months Ended  October 31,** |   |
|-----------------------------------------------------------------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
| **(in thousands, except per share amounts)**                                            |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
| Numerator:                                                                              |   |                                |   |                               |   |   |   |   |   |
| Loss from continuing  operations                                                        |   | $                                   | (7,048 | )                                  | $      | (8,510 | ) | $ | (20,049 | ) | $ | (21,538 | ) |
| Cumulative effect of an  accounting change                                              |   | —                              |   | (4,175                             | )      | — |   | (4,175 | ) |
|                                                                                    |   |                                |   |                               |   |   |   |   |   |
| Net loss                                                                                |   | $                                   | (7,048 | )                                  | $      | (12,685 | ) | $ | (20,049 | ) | $ | (25,713 | ) |
|                                                                                    |   |                                |   |                               |   |   |   |   |   |
| Denominator:                                                                            |   |                                |   |                               |   |   |   |   |   |
| Denominator for basic  and diluted loss per share - weighted-average shares outstanding |   | 30,759                              |   | 29,157                             |   | 30,498 |   | 28,453 |   |
|                                                                                    |   |                                |   |                               |   |   |   |   |   |
| Loss per share from  continuing operations                                              |   | $                                   | (.23   | )                                  | $      | (.29 | ) | $ | (.66 | ) | $ | (.75 | ) |
| Cumulative effect per  share from an accounting change                                  |   | —                              |   | (.15                               | )      | — |   | (.15 | ) |
| Basic and diluted loss  per share                                                       |   | $                                   | (.23   | )                                  | $      | (.44 | ) | $ | (.66 | ) | $ | (.90 | ) |

 

For the three months ended October 31, 2003 and October 31, 2002 andfor the nine months ended October 31, 2003 and October 31, 2002, respectively,basic earnings per share and diluted earnings per share are the same due to thenet loss for those periods.  During thethree months ended October 31, 2003 and 2002, respectively, the Companyexcluded options to purchase 915,643 and 330,895 shares of common stock.  During the nine months ended October 31,2003 and 2002, respectively, the Company excluded options to purchase 652,964and 828,935 shares of common stock.

 

**5.     Divestitures**

 

In April 2000, pursuant to an asset purchaseagreement, the Company sold the principal assets of its DVD product group,primarily consisting of fixed assets and intangible assets, to LSI Logic(“Buyer”).  The Company received $11.7million in a lump-sum cash payment and an additional $3.1 million wascontingent on the Company’s performance of certain obligations related to thetransfer of licenses with third parties to the Buyer. The Company wrote-offapproximately $3.6 million in capitalized intellectual property, fixed assetsand prepaid expenses related to the DVD product group that was transferred tothe 

 

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Buyer.  Inaddition, the Company incurred approximately $0.6 million in transaction costs,approximately $2.3 million in retention packages for the affected employees,and $0.3 million in additional costs during fiscal 2001. The Company received a$1.5 million cash payment which was previously contingent on the Company’sperformance of certain obligations related to the transfer of licenses withthird parties to the Buyer in fiscal 2001. As a result, the Company recorded a pre-tax gain of approximately $6.5million on the sale, which is recorded in income, net of expenses, from thesale of DVD assets on the consolidated condensed statements of operations forthe year ended January 31, 2001.  In thefirst quarter of fiscal 2003, the Company received the remaining contingentpayment of $1.6 million upon completing the transfer of licenses with thirdparties to the Buyer, and recorded as the amount as a gain in the consolidatedcondensed statement of operations for the fiscal year ended January 31, 2003.

 

**6.     Inventories**

 

Inventoriesare stated at the lower of cost or market value. Cost is determined by thefirst-in, first-out method.  The Companywrites down the inventory value for estimated excess and obsolete inventory,based on management’s assessment of future demand and market conditions.  If actual future demand or market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.

 
| **Inventory consists of:  (in thousands)** |   | **October  31,  2003** |   | **January  31,  2003** |   |
|--------------------------------------------|--------|------------------------|--------|------------------------|--------|
|                                       |   |                   |   |                   |   |
| Raw materials                              |   | $                      | 62     |                   | $      | 117 |   |
| Work in process                            |   | 63                     |   | 102                    |   |
| Finished goods                             |   | 159                    |   | 316                    |   |
| Total                                      |   | $                      | 284    |                   | $      | 535 |   |

 

**7.     AccumulatedOther Comprehensive Income (Loss)**

 

Totalaccumulated other comprehensive income (loss) was $(24) thousand at October 31,2003 and $9 thousand at January 31, 2003. Accumulated other comprehensive income (loss) consists entirely ofunrealized gains (losses) on available for sale securities.

 

**8.     Intangible Assets**

 

Thefollowing table provides a summary of the carrying amount of intangible assetsthat will continue to be amortized:

 

Intangibleassets subject to amortization were as follows (in thousands):

 
| **October  31, 2003**           |   | **Cost** |   | **Accumulated****Amortization** |   | **Net** |   |
|---------------------------------|--------|----------|--------|---------------------------------|--------|---------|--------|
| Licensed  intellectual property |   | $        | 3,275  |                            | $      | (384    | )      | $ | 2,891 |   |
| Core technology                 |   | 1,800    |   | (1,100                          | )      | 700     |   |
|                            |   | $        | 5,075  |                            | $      | (1,484  | )      | $ | 3,591 |   |

 
| **January  31, 2003**           |   | **Cost** |   | **Accumulated  Amortization** |   | **Net** |   |
|---------------------------------|--------|----------|--------|-------------------------------|--------|---------|--------|
| Licensed  intellectual property |   | $        | 3,244  |                          | $      | (45     | )      | $ | 3,199 |   |
| Core technology                 |   | 1,800    |   | (650                          | )      | 1,150   |   |
| Patents                         |   | 1,697    |   | (1,697                        | )      | —  |   |
|                            |   | $        | 6,741  |                          | $      | (2,392  | )      | $ | 4,349 |   |

 

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Amortization expense for other intangible assets was$423 thousand and $450 thousand for the three months ended October 31, 2003 and2002, respectively. Amortization expense for other intangible assets was $789thousand and $1,452 thousand for the nine months ended October 31, 2003 and2002, respectively.  Licensed intellectualproperty and core technology are amortized over three years.  Estimated annual amortization expense forother intangible assets is as follows as of October 31, 2003:

 

| **Fiscal years ending January 31,  (in thousands)** |   |   |   |
|-----------------------------------------------------|--------|--------|--------|
| 2004                                                |   | $      | 423    |   |
| 2005                                                |   | 1,642  |   |
| 2006                                                |   | 1,047  |   |
| 2007                                                |   | 479    |   |
| Total                                               |   | $      | 3,591  |   |

 

**9.     Obligationsunder Capital Leases**

 

Infiscal 2003, the Company entered into capital leases to finance softwarelicenses used in the design of semiconductors. Obligations under capital leasesrepresent the present value of future payments under the lease agreements.Property, plant and equipment include the following amounts for leases thathave been capitalized:

 
| **(in thousands)**               |   | **October  31,  2003** |   | **January  31,  2003** |   |
|----------------------------------|--------|------------------------|--------|------------------------|--------|
| Software under capital lease     |   | $                      | 4,073  |                   | $      | 4,073 |   |
| Accumulated amortization         |   | (1,399                 | )      | (381                   | )      |
| Net software under capital lease |   | $                      | 2,674  |                   | $      | 3,692 |   |

 

Amounts capitalized under leases are being amortized over a three-yearperiod.

 

Future minimum payments under the capital leasesconsist of the following, as of October 31, 2003:

 

 
| **Fiscal year ending January 31,  (in thousands)** |   |   |   |
|----------------------------------------------------|--------|--------|--------|
| 2004                                               |   | $      | 658    |   |
| 2005                                               |   | 1,910  |   |
| 2006                                               |   | 829    |   |
| Total minimum lease payments                       |   | 3,397  |   |
| Less: amount representing interest                 |   | (319   | )      |
| Present value of net minimum lease payments        |   | 3,078  |   |
| Less: current portion                              |   | (1,475 | )      |
| Long-term portion                                  |   | $      | 1,603  |   |

 

**10.        Contingencies**

 

As ageneral matter, the semiconductor industry is characterized by substantiallitigation, regarding patent and other intellectual property rights.  In December 1998, the Company filed alawsuit in the United States District Court for the District of Delawareseeking damages and an injunction against Trident Microsystems, Inc.  The suit alleges that Trident’s embeddedDRAM graphics accelerators infringe certain patents held by the Company.  In January 1999, Trident filed a counterclaim against the Company alleging 

 

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an attempted monopolization in violation of antitrustlaws, arising from NeoMagic’s filing of the patent infringement action againstTrident. The Court ruled that there was no infringement by Trident. The Companyfiled an appeal in the United States Court of Appeals, for the FederalCircuit.  On April 17, 2002, the UnitedStates Court of Appeals for the Federal Circuit affirmed the lower court’sjudgment of non-infringement on one patent and vacated the court’s judgment ofnon-infringement on another patent, thereby remanding it to the lower court forfurther proceedings. In November 2002, the lower court heard oral arguments oncross-motions for summary judgment on the matter.  In May 2003, the lower court ruled in favor of Trident. In August2003 the Company started the process to file an appeal in the United StatesCourt of Appeals, for the Federal Circuit. Management believes the Company has valid defenses against Trident’sclaims and no accrual has been recorded for the potential loss contingencyrelating to the Trident counter-suit. There can be no assurance as to theresults of the patent infringement appeal and the counter-suit for antitrustfiled by Trident.

 

**11.        ProductWarranty**

 

The Company generally sells products with a limitedwarranty of product quality and a limited indemnification of customers againstintellectual property infringement claims related to the Company’s products.The Company accrues for known warranty and indemnification issues if a loss isprobable and can be reasonably estimated, and accrues for estimated incurredbut unidentified issues based on historical activity. The accrual and therelated expense for known issues were not significant as of and for the ninemonths period ended October 31, 2003 and 2002. Due to product testing, theshort time between product shipment and the detection and correction of productfailures, and a low historical rate of payments on indemnification claims, theaccrual based on historical activity and the related expense were notsignificant as of and for the nine month period ended October 31, 2003 and2002.

 

**Part I.  Financial Information**

 

**Item 2****.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

Whenused in this discussion, the words “expects,” “anticipates,” “believes” andsimilar expressions are intended to identify forward-looking statements.  Such statements reflect management’s currentintentions and expectations. Examples of such forward-looking statementsinclude statements regarding future revenues, expenses, losses and cash flows,capital requirements, the launch of new products and research and developmentactivities.  However, actual events andresults could vary significantly based on a variety of factors including, butnot limited to: customer acceptance of new NeoMagic products, the marketacceptance of handheld system products developed and marketed by customers thatuse the Company’s products, the Company’s ability to execute product andtechnology development plans on schedule, and the Company’s ability to accessadvanced manufacturing technologies in sufficient capacity without significantcash pre-payments or investment.  Thesefactors along with those set forth below under “Factors that May AffectResults,” are subject to risks and uncertainties that could cause actualresults to differ materially from those projected. These forward-looking statementsspeak only as of the date hereof. The Company expressly disclaims anyobligation or undertaking to release publicly any updates or revisions to anyforward-looking statements contained herein, to reflect any changes in theCompany’s expectations with regard thereto or any changes in events, conditionsor circumstances on which any such statement is based.

 

# **Overview**

 

NeoMagicdesigns, develops and sells high performance applications processors marketedunder the MiMagicTM name.  The MiMagicfamily is designed to enable sophisticated multimedia functionality within alow-power, high performance system-on-chip (SOC).  The MiMagic Applications Processors are targeted atmultimedia-enabled mobile phones and wireless personal digital assistants(PDAs).  In the past, the Companyprovided semiconductor solutions for the notebook PC multimedia acceleratormarketplace.

 

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In calendar 2000,the Company exited this market and is now focused solely on developing,manufacturing and selling applications processors for the handheld systemsmarket.  The Company is now generatingrevenues from this product effort. Currently, customers are shipping products with the MiMagic 3Applications Processor.  By mid-yearcalendar 2004, the Company expects customers to ship new handheld systems thatuse the MiMagic 5 chips.  The Company launchedits newest product, the MiMagic 6, in June 2003.  As of October 2003, the first samples of the MiMagic 6 chip werereceived and will be shipping into customer trials beginning in December of2003.  The Company believes that theMiMagic 6 provides some of the highest multimedia processing performance amonglow power applications processors available today.

 

NeoMagichas established strategic relationships with third-party manufacturing partnersto produce semiconductor products for the Company.  Pursuant to these strategic relationships, NeoMagic designs theoverall product, including the logic and analog circuitry, and themanufacturing partners manufacture the wafers, perform testing and package theproducts.  NeoMagic has corecompetencies in integrating logic, analog and memory as well as developinggraphics, video, 3D and other multimedia technologies.  By combining these core competencies withthird-party drivers, middleware, operating system software, and powermanagement, NeoMagic develops solutions that facilitate the mobilization ofmultimedia applications.

 

NeoMagicintroduced its first applications processor, the MiMagic 3 (NMS7210), in June2002.  This product is currentlyshipping to customers with consumer electronic end markets that include mobilephones, video recorders and MP3 players. The Company expects this product to continue shipping through calendar2004.

 

NeoMagicintroduced the MiMagic 5 Applications Processor (NMS9200) in November 2002, andbegan shipping product samples in February 2003.  The Company expects to start revenue shipments in mid-year calendar2004, depending upon customer production schedules.

 

TheMiMagic 6 Application Processor (NMS9600) was launched in June of 2003.  The MiMagic 6 is based on NeoMagic’sAssociative Processor Array, or APA, which forms its multimedia engine.  Existing applications processor solutionsuse a sequential processing flow that typically operates on each individualdata element in sequence, relying on ever-faster processor clock cycles to gainperformance.  This requires largeamounts of power and creates performance bottlenecks.  Conversely, APA merges processing and memory.  APA processes multiple bits of data inparallel, in a single clock cycle, thus boosting performance while using lesspower.  Because of this, the MiMagic 6is able to perform an order of magnitude more operations per clock cycle than aconventional applications processor at the same power.  With that computational horsepower, theMiMagic 6 is able to provide value-add camera capabilities like zoom, low-lightand bright-light adjustment and advanced 3-D gaming features, without addingtransistors. With its ability to handle large amounts of data simultaneouslyand at lower clock rates, the APA platform is targeted at sophisticatedmultimedia data such as images, video and 3D graphics. The Company expects tobegin shipping product samples to potential customers during the fourth quarterof fiscal 2004.  As of November 2003,the Company is demonstrating this chip in silicon to customers.

 

TheCompany’s fiscal year end is January 31. Any references herein to a fiscal year refer to the year ended January31 of such year.  The third fiscalquarters of 2004 and 2003 ended on October 26, 2003 and October 27, 2002,respectively.  For ease of presentation,the accompanying financial statements have been shown as ending on the last dayof the calendar month of October.

 

### **Critical AccountingPolicies**

 

NeoMagic’sdiscussion and analysis of its financial condition and results of operationsare based upon its consolidated financial statements, which have been preparedin accordance with accounting 

 

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principlesgenerally accepted in the United States. The preparation of these financialstatements requires the Company to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, theCompany evaluates its estimates, including those related to goodwill,intangible assets, and long-lived assets, inventories, revenue recognition andincome taxes.  The Company bases itsestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the amount and timing of revenue andexpenses and the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from these estimatesunder different assumptions or conditions.

 

**Goodwill,Intangible Assets and Long Lived Assets**

 

NeoMagichas significant tangible and intangible assets on its balance sheet, includingother purchased intangibles related to acquisitions.

 

Inassessing the recoverability of intangible assets with indefinite lives, theCompany must make assumptions about the estimated future cash flows and otherfactors to determine the fair value of these assets.  Assumptions about future revenue and cash flows requiresignificant judgment because of the current state of the economy, thefluctuation of actual revenue, and the timing of expenses.

 

As aresult of the transitional impairment tests required under SFAS 142, theCompany recorded a $4.2 million non-cash charge to reduce the carrying value ofits goodwill to zero, which is shown as a cumulative effect of a change inaccounting principle in the third quarter of fiscal 2003.

 

Long-lived assets and asset groups are evaluated for impairmentwhenever events or changes in circumstances indicate that the carrying amountof such assets may not be recoverable, or at least annually.  The estimated future cash flows are basedupon, among other things, assumptions about expected future operatingperformance and may differ from actual cash flows.  Long-lived assets evaluated for impairment are grouped with otherassets to the lowest level for which identifiable cash flows are largelyindependent of the cash flows of other groups of assets and liabilities.  If the sum of the projected undiscountedcash flows  (excluding interest) is lessthan the carrying value of the assets, the assets will be written down to theestimated fair value in the period in which the determination is made.

 

Intangiblesassets are carried and reported at acquisition cost, net of accumulatedamortization subsequent to acquisition. The acquisition cost is amortized overestimated useful lives, which range from 2 to 3 years. Changes in circumstancessuch as the passage of new laws or changes in regulations, technologicaladvances, changes to the Company’s business model, or changes in the capitalstrategy could result in the actual useful lives differing from initialestimates.  In those cases where theCompany determines that the useful life of a long-lived asset should berevised, the Company will depreciate the net book value in excess of theestimated residual value over its revised remaining useful life. Factors suchas changes in the planned use of equipment, customer attrition, contractualamendments, or mandated regulatory requirements could result in shorteneduseful lives of intangible assets.

 

Intangibleassets are reviewed for impairment whenever events or circumstances indicateimpairment might exist, or at least annually, in accordance with SFAS 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.” Projectedundiscounted net cash flows expected to be derived from the use of those assetsare compared to the respective net carrying amounts to determine whetherimpairment exists. Impairment, if any, is based on the excess of the carryingamount over the fair value of those assets. The determination of the netcarrying value of goodwill and intangible assets and the extent to which, inany, there is impairment are dependent on significant estimates and judgmentson the Company’s part, including the useful life over which the intangibleassets are to be amortized, and the estimates of the value of future cashflows, which are based upon further estimates of future revenue, expenses andoperating margins.

 

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During the first quarter of fiscal 2003, the Company wrote-off licensedintangible properties with a net book value of $0.5 million relating tolicensed intellectual property that will no longer be used.

 

Duringthe third and fourth quarters of fiscal 2003, the Company also determined thatcertain intangible assets purchased as part of the LinkUp Systems Corporationacquisition completed in December 2001 were impaired and recorded a totalimpairment charge of $1.0 million.

 

**InventoryValuation**

 

The Company’s inventory valuation policy stipulates that at the end ofeach reporting period we write-down or write-off our inventory for estimatedobsolescence or unmarketable inventory. The amount of the write-down orwrite-off is equal to the difference between the cost of the inventory and theestimated market value of the inventory based upon reasonable assumptions aboutfuture demand and market conditions. If actual market conditions are lessfavorable than those projected by management, additional inventory write-downsor write-offs may be required. Additionally, as we introduce productenhancements and new products, demand for our existing products in inventorymay decrease.

 

### **Revenue Recognition**

 

The Company recognizes revenue from product sales when the products areshipped to customers; other than distributors, title has transferred, and nosignificant obligations remain. In addition, the Company requires thefollowing: (i) execution of a written customer order, (ii) delivery of theproduct, (iii) fee is fixed or determinable, and (iv) collectibility of theproceeds is probable. The Company’s shipment terms are FOB shipping point.

 

Withrespect to products shipped to distributors, the Company generally defersrecognition of product revenue until the distributors sell their products totheir customers. On occasion, however, the Company will sell products with “Endof Life” status to its distributors under special arrangements without anyprice protection or return privileges for which the Company recognizes revenueupon transfer of title, based on shipping terms.

 

At the end of each accounting period, the Company makes a determinationof certain factors including sales returns and allowances, which could affectthe amount of revenue recorded for the period. Sales returns provisions includeconsiderations for known but unprocessed sales returns and estimation forunknown returns based on historical experiences.

 

### **Deferred Taxes**

 

The Company records a valuation allowance to reduce its deferred tax assetsto the amount that is more likely than not to be realized. Based on theuncertainty of future pre-tax income, the Company has fully reserved itsdeferred tax assets. In the event the Company was to determine that it would beable to realize its deferred tax assets in the future, an adjustment to thedeferred tax asset would increase income in the period when such determinationwas made. The Company has also provided reserves for certain potential taxliabilities. If such amounts ultimately prove to be unnecessary, the resultingreversal of such reserves would result in tax benefits being recorded in theperiod when the reserves are no longer deemed necessary.

 

**Results of Operations**

 

**Net Sales**

 

Net sales were $0.5 million and $1.3 million for the three months andnine months ended October 31, 2003, respectively, compared to $0.7 million and$1.5 million for the three months and nine months 

 

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ended October 31, 2002.  Net sales decreased in the three and ninemonths ended October 31, 2003 due to customer delays in bringing their MiMagic3 programs to commercial production.

 

Sales to customers located outside the United States (including salesto the foreign operations of customers with headquarters in the United States,and foreign system manufacturers that sell to United States-based OEMs)accounted for 91% and 90% of net sales in the three months ended October 31,2003 and 2002, respectively.  Exportsales accounted for 88% and 89% of net sales in the nine months ended October31, 2003 and 2002, respectively. All sales transactions were denominated inUnited States dollars.

 

Two customersaccounted for 39% and 35% of net sales for the three months ended October 31,2003.  For the same period in the prioryear, those customers accounted for 10% and 15%, respectively, of netsales.  In addition, two customers thatboth accounted for less than 10% of net sales for the three months endedOctober 31, 2003, accounted for 46% and 14%, respectively, of net sales for thesame period last year.  Four customersaccounted for 33%, 29%, 12% and 11% of net sales for the nine months endedOctober 31, 2003.  For the same periodin the prior year, those customers accounted for 20%, 21%, 20% and 20%,respectively, of net sales.

 

**Gross Margin (Loss)**

 

Grossloss was $137 thousand and $492 thousand for the three months ended October 31,2003 and 2002, respectively.  Gross losswas $298 thousand and $941 thousand in the nine months ended October 31, 2003and 2002, respectively.  The negativegross margins in the three and nine month periods ended October 31, 2003 aregenerally due to under absorption of manufacturing overhead resulting fromrelatively low production levels.  Inaddition, in the first quarter of fiscal 2004 the Company began reviewing thepercentage of time spent by manufacturing employees between production anddevelopment. The Company allocated $50 thousand and $161 thousand of wage costsrelated to development efforts to research and development expenses in the threeand nine months ended October 31, 2003, which had a favorable impact on grossmargin.  Cost of sales includedamortization of developed technology of $112 thousand and $336 thousand for thethree and nine months ended October 31, 2002. In addition, the Company wrote off $367 thousand of developed technologyin the three months ended October 31, 2002 as part of and impairmentcharge.  Developed technology was fullywritten off as of January 31, 2003 and, therefore, had no impact on cost ofsales in fiscal 2004.

 

## **Research and Development Expenses**

 

Research anddevelopment expenses include compensation and associated costs relating todevelopment personnel, amortization of intangible assets and prototyping costs,which are comprised of photomask costs and pre-production wafer costs.  Research and development expenses were $5.3million and $5.7 million for the three months ended October 31, 2003 and 2002,respectively. Research and development expenses were $14.8 million and $18.1million for the nine months ended October 31, 2003 and 2002, respectively.  These expenses include amortization ofdeferred compensation of $0.1 million and $0.1 million for the three monthsended October 31, 2003 and 2002, respectively, and $0.3 million and $0.9million for the nine months ended October 31, 2003 and 2002, respectively.  The decrease of $0.4 million for the threemonths ended October 31, 2003 is primarily related to lower softwaremaintenance costs ($0.3 million) and lower labor costs ($0.1 million), lowerconsulting costs ($0.1 million) offset by increased mask costs ($0.2million).  The decrease of $3.3 millionfor the nine months ended October 31, 2003 is primarily related to lower laborcosts ($0.7 million), lower amortization of deferred compensation ($0.6 million),lower amortization of acquired and licensed intangibles ($0.6 million) andlower software maintenance costs ($0.7 million). In addition, included in theexpenses for the nine months ended October 31, 2002, were expenses of $0.5million to write off certain licensed intellectual property. The Company hasmade, and intends to continue to make, significant investments in research anddevelopment as it focuses on developing products for the handheld systemsmarket.

 

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# **Sales,General and Administrative Expenses**

 

Sales, general and administrative expenses were $1.8 millionand $2.1 million for the three months ended October 31, 2003 and 2002,respectively. Sales, general and administrative expenses were $5.4 million and$7.8 million for the nine months ended October 31, 2003 and 2002, respectively.These expenses include amortization of deferred compensation of $0.1 millionand $0.1 million for the three months ended October 31, 2003 and 2002,respectively, and $0.2 million and $0.9 million for the nine months endedOctober 31, 2003 and 2002, respectively. Sales, general, and administrativeexpenses decreased slightly for the three months ended October 31, 2003. Sales,general and administrative expenses decreased for the nine months ended October31, 2003 primarily due to lower labor costs ($1.1million) and loweramortization of deferred compensation ($0.7 million).

 

**Impairment of Certain Acquired IntangibleAssets**

 

During the third quarterof fiscal 2003, the Company determined that certain intangible assets purchasedas part of the LinkUp Systems Corporation acquisition completed in December2001 were impaired and recorded a total impairment charge of $873 thousandduring the period.  Of the totalimpairment charge, $367 thousand related to impairment of certain acquiredintangibles that were capitalized relating to developed technology. Theimpairment was caused by a decline in the related sales forecasts of productsassociated with the intangibles. The impairment charge relating to developedtechnology is included in the cost of sales section of the consolidatedstatements of operations.  In addition,the Company also recorded a $506 thousand impairment charge with respect tointangibles relating to customer relationships. Several key customers with whomthe Company was engaged have abandoned their related product plans, which ledto the impairment. The impairment charge relating to customer relationships isincluded in the operating expenses section of the consolidated statements ofoperations.

 

**Special Charges**

 

InJanuary 2001, the Company extended its wafer supply agreement with InfineonTechnologies AG of Germany (“Infineon”) through fiscal 2004 to ensure futurewafer supply for the Company’s new product efforts.  The terms of the agreement provided that NeoMagic would make useof Infineon’s 0.20 micron and 0.17 micron embedded DRAM (eDRAM) processtechnologies.  The agreement alsoprovided for access to additional manufacturing capacity and to more advancedprocess technologies to be developed by Infineon. NeoMagic provided $15.0million in guarantees towards its wafer purchases over the term of theagreement.  The amount of guarantee wasincluded as restricted cash on the Company’s Consolidated Balance Sheet, as ofJanuary 31, 2002. Due to uncertainties over Infineon’s continued eDRAM productdevelopment, the Company decided not to use Infineon’s eDRAM technology for itsfuture production. Based on negotiations between NeoMagic and Infineon onrestructuring the wafer supply agreement with the intent to release NeoMagicfrom the related guarantee, the Company recorded $3.6 million in charges, whichreflects the value of the final settlement in fiscal 2003.  The $3.6 million charge is composed of a$1.5 million cash payment and the issuance of $2.1 million in commonstock.  The Company booked $1.4 millionof this charge in the first quarter of fiscal 2003 based on discussions withInfineon at that time and booked $2.2 million in the second quarter of fiscal2003 to reflect the final settlement.

 

**Income, Net ofExpenses, from Sale of DVD Assets**

 

InApril 2000, pursuant to an asset purchase agreement, the Company sold theprincipal assets of its DVD product group, primarily consisting of fixed assetsand intangible assets, to LSI Logic (“Buyer”). The Company received $11.7 million in a lump-sum cash payment and anadditional $3.1 million was contingent on the Company’s performance of certainobligations related to the transfer of licenses with third parties to the Buyer.The Company wrote-off approximately $3.6 million in capitalized intellectualproperty, fixed assets and prepaid expenses related to the DVD product groupthat was transferred to the Buyer.  Inaddition, the Company incurred approximately $0.6 million in transaction costs,approximately $2.3 million in retention packages for the affected employees,and $0.3 million in additional costs during fiscal 2001. The Company received a$1.5 million cash payment which was previously contingent on the Company’s performanceof certain obligations related to the transfer of licenses with third partiesto the

 

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Buyer in fiscal2001.  As a result, the Company recordeda pre-tax gain of approximately $6.5 million on the sale, which is recorded inincome, net of expenses, from the sale of DVD assets on the consolidatedcondensed statements of operations for the year ended January 31, 2001.  In the first quarter of fiscal 2003, theCompany received the remaining contingent payment of $1.6 million uponcompleting the transfer of licenses with third parties to the Buyer, andrecorded the amount as a gain in the consolidated condensed statement ofoperations for the fiscal year ended January 31, 2003.

 

**Interest Income**

 

TheCompany currently earns interest on its cash equivalents and short-terminvestments and previously on its long-term investments and restrictedcash.  Interest and other income was$0.1 million and  $0.3 million for thethree months ended October 31, 2003 and 2002, respectively.  Interest and other income was $0.6 millionand $1.3 million for the nine months ended October 31, 2003 and 2002,respectively. The decrease for three months ended October 31, 2003 is primarilydue to lower average cash and short-term investment balances.  The decrease for the nine months endedOctober 31, 2003 in interest and other income is primarily due to significantlylower interest rates and to lower average cash and short-term investmentbalances.

 

**Other Income(Expense)**

 

Other income (expense) was $215 thousand and $(23) thousand for thethree months ended October 31, 2003 and 2002, respectively.  Other income was $172 thousand and $232thousand for the nine months ended October 31, 2003 and 2002,respectively.  The Company acquiredshares of Margi Systems, Inc. preferred stock in January of 1998, for $300,000.The Company wrote off the investment fully during the fourth quarter of fiscalyear 2001, based on the Company’s views of the financial prospects of MargiSystems at such time.  Margi Systems wasacquired by Harman International Industries, Inc. in September 2003.  In connection with the acquisition, theCompany received $255 thousand for its holdings of Margi Systems preferredstock.  The proceeds from the previouslywritten off investment is shown as other income in the consolidated condensedstatement of operations for the three and nine months ended October 31,2003.  The Margi proceeds for the threeand nine months ended October 31, 2003 are partially offset by foreign currencyexchange losses.  Other income for thenine months ended October 31, 2002 primarily represents $200 thousand receivedas final settlement with a distributor of the Company’s legacy products.

 

### **Interest Expense**

 

Interestexpense was $66 thousand and $0 for the three months ended October 31, 2003 and2002, respectively. Interest expense was $226 thousand and $0 for the ninemonths ended October 31, 2003 and 2002, respectively.  Interest expense for the three and nine months ended October 31,2003 is due to new capital leases entered into in the latter half of fiscal2003.

 

**Income Taxes**

 

In thethree and nine months ended October 31, 2003, taxes consisted of foreign incometaxes.  The Company recorded a $6million tax benefit for the three months ended April 30, 2002, primarilyrelated to changes in the federal tax law. The Job Creation and Worker Assistance Act of 2002 was enacted on March9, 2002 and contained provisions extending the net loss carry-back period fromthree to five years.  This changepermitted the Company to utilize net operating losses incurred in fiscal 2001to recover taxes paid in prior periods. The $6 million benefit representsadditional refunds that the Company claimed on the 2001 net operating losscarry-back due to the change in tax law.

 

**Cumulative Effect of Change in Accounting Principle**

 

The Company completed the transitional impairment testing of goodwillusing the two-step process prescribed in SFAS 142 during the third quarter offiscal 2003. As a result, the Company recorded a $4.2

 

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million non-cashcharge to reduce the carrying value of its goodwill to zero, which is shown asa cumulative effect of a change in accounting principle in the third quarter offiscal 2003.

 

**Liquidity and CapitalResources**

 

The Company’s cash, cash equivalents and short-term investmentsdecreased $18.5 million in the nine months ended October 31, 2003 to  $48.6 million from $67.1 million at January31, 2003.

 

Cash and cash equivalents used in operating activities for the ninemonths ended October 31, 2003 was $17.5 million, compared to $1.0 million ofnet cash provided by operating activities for the nine months ended October 31,2002.  The cash used in operatingactivities stems primarily from a net loss of $20.0 million, as well asdecreases in accounts payable ($1.0 million) and in other accruals ($1.1million), partially offset by non-cash depreciation and amortization ($2.9million), deferred compensation amortization charges ($0.5 million), taxbenefit from employee stock options ($0.4 million) and decreases in inventory($0.3 million) and other current assets ($0.4 million).

 

Net cash usedin investing activities for the nine months ended October 31, 2003, was $9.7million, compared to $4.4 million of net cash provided by investing activitiesfor the nine months ended October 31, 2002. Net cash used in investingactivities related primarily to net purchases of short-term investments of $9.3million and purchases of fixed assets and intangibles of $0.4 million.

 

Net cash usedin financing activities was $0.5 million for the nine months ended October 31,2003, compared to $0.5 million of net cash provided by financing activities forthe nine months ended October 31, 2002. The net cash used in financingactivities represents payments on capital lease obligations offset somewhat byproceeds from the issuance of common stock.

 

AtOctober 31, 2003, the Company’s principal sources of liquidity included cash,cash equivalents and short-term investments of $48.6 million.  The Company believes that it will notgenerate cash from operations during the next twelve months. The Companybelieves the current cash, cash equivalents and short-term investments will satisfythe Company’s projected working capital and capital expenditure requirementsthrough the next twelve months. After this period, capital requirements willdepend on many factors, including general economic conditions, the rate of netsales growth, the timing and extent of spending to support research anddevelopment programs, the timing of any new product introductions andenhancements to existing products, and market acceptance of the Company’sproducts.  To the extent that existingcash, cash equivalents and short-term investment balances and any cash fromoperations are insufficient to fund the Company’s future activities, theCompany may need to raise additional equity or debt financing in thefuture.  There can be no assurance thatadditional equity or debt financing, if required, will be available onacceptable terms or at all.

 

In May1996, the Company moved its principal headquarters to a new facility in SantaClara, California, under a non-cancelable operating lease that expired in April2003. In January 1998, the Company entered into a second non-cancelableoperating lease for the building adjacent to its principal headquarters.  This lease had a co-terminus provision withthe original lease, which expired in April 2003.  In March 2002, the Company extended the term for 45,000 square feetunder this lease for another seven years with a termination date of April2010.  The Company leases offices inIndia and Israel under operating leases that expire at various times throughDecember 2006.  The future minimumpayments relating to the facility leases are included in the contractualobligations table presented below.

 

TheCompany has entered into capital leases relating to software licenses.  Refer to note 9 of the consolidatedcondensed financial statements for additional information.  The future minimum payments relating to thesoftware leases are included in the contractual obligations table presentedbelow.

 

The following summarizes the Company’s contractualobligations at October 31, 2003, and the expected effect of such obligations onour liquidity and cash flow (in thousands) in the future.

 

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|                                |   | **2004** |       | **2005** |       | **2006** |       | **2007** |       | **2008** |       | **Thereafter** |       | **Total** |       |
|-------------------------------------|--------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| **CONTRACTUAL OBLIGATIONS**         |   |     | ** ** |     | ** ** |     | ** ** |     | ** ** |     | ** ** |           | ** ** |      | ** ** |
| Operating  leases                   |   | $        | 289        |     | $          | 1,137    |       | $        | 1,090      |     | $          | 1,117          |       | $         | 1,046      |   | $ | 2,450 |   | $ | 7,129 |   |
| Capital  leases                     |   | 658      |       | 1,910    |       | 829      |       | —   |       | —   |       | —         |       | 3,397     |       |
| Non-cancelable  purchase orders     |   | 22       |       | 33       |       | —   |       | —   |       | —   |       | —         |       | 55        |       |
|                                |   |     |       |     |       |     |       |     |       |     |       |           |       |      |       |
| Total  contractual cash obligations |   | $        | 969        |     | $          | 3,080    |       | $        | 1,919      |     | $          | 1,117          |       | $         | 1,046      |   | $ | 2,450 |   | $ | 10,581 |   |
|                                     |        |          |            |          |            |          |            |          |            |          |            |                |            |           |            |  |  |  |  |  |  |  |  |

 

As described in note 11 to the consolidatedcondensed financial statements, the warranty liabilities are not material as ofOctober 31, 2003.

 

**Factors that MayAffect Future Results**

# ** **

# **WeExpect to Continue to Incur Significant Losses in Fiscal 2004**

 

The Company hasbeen incurring substantial losses as it invests heavily in new productdevelopment in advance of achieving significant customer sales.  This is expected to continue in fiscal year2004.  The Company’s ability to achievecash flow breakeven is likely to depend on customer acceptance and revenuegeneration from its MiMagic 5 and its MiMagic 6, which has recently beenannounced.  However, given the length ofcustomer design-in cycles, the Company will incur significant additional lossesin fiscal 2004.

 

**OurAnnual and Quarterly Performance May Fluctuate**

 

The Company’s quarterly and annual results of operations are affectedby a variety of factors that could materially adversely affect net sales, grossmargin and operating results.  Thesefactors include, among others, the ability of the Company to increase itscustomer base and its sales, the abilities of manufacturing subcontractors tomake adequate and timely deliveries, access to advanced production processtechnologies from manufacturing subcontractors, and recruiting and retainingemployees including those with engineering expertise in new disciplines. Inparticular, the Company’s new product development efforts and customerengagements in System-on-Chip integration and supporting multimediatechnologies such as MPEG-4 streaming video represent new endeavors andconsequently carry greater risks of successful and timely execution. Any one ormore of these factors could result in the Company failing to achieve its expectationsas to future revenues and profits. Furthermore, the majority of the Company’s sales were historically made,and are expected to continue to be made, on the basis of purchase orders ratherthan pursuant to long-term purchase agreements, which increases the difficultyof forecasting sales.  The Company maybe unable to adjust spending sufficiently in a timely manner to compensate forany unexpected sales shortfall, which could materially adversely affect quarterlyoperating results.  Accordingly, theCompany believes that period-to-period comparisons of its operating resultsshould not be relied upon as an indication of future performance.  In addition, the results of any quarterlyperiod are not indicative of results to be expected for a full fiscalyear.  In future quarters, the Company’soperating results may be below the expectations of public market analysts orinvestors.

 

# **Our Financial Results could be Affected by Changes inAccounting Rules**

 

In August 2001, the FASB issued SFAS 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” SFAS 144 requires us to performimpairment analysis on our long-lived assets, other than goodwill, to be heldand used, whenever events or changes in circumstances indicate the carryingamount may not be recoverable. An impairment loss will be recognized if thecarrying amount of a long-lived asset exceeds its fair value. SFAS 144 retainsthe fundamental provisions of SFAS 121 related to (i) the recognition andmeasurement of the impairment of long-lived assets to be held and used, and(ii) the measurement of long-lived assets to be disposed of by sale. As SFAS144 excludes goodwill, certain long-lived assets may be subject to impairmentcharges sooner than they would have been recorded under SFAS

 

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121, which SFAS144 replaces. During the third and fourth quarter of fiscal 2003, we recordedimpairment charges of $873 thousand and $170 thousand, respectively, related toour long-lived assets as a result of our SFAS 144 analysis. If economicconditions in our industry continue to deteriorate and adversely affect ourbusiness, we could be required to record additional impairment charges relatedto our long-lived assets, which could have a material adverse effect on ourresults of operations and financial condition.

 

Our financial results could be affected by potential changes in theaccounting rules governing the recognition of stock-based compensation expense.We measure compensation expense for our employee stock plans under theintrinsic value method of accounting prescribed by Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees.” In addition, weprovide pro forma disclosures of our operating results in our Notes to ConsolidatedFinancial Statements as if the fair value method of accounting had been appliedin accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Hadwe accounted for our compensation expense under the fair value method ofaccounting prescribed by SFAS 123, the charge would have been significant,totaling $5.6 million, $6.7 million and $6.3 million during fiscal 2003, 2002and 2001, respectively. Currently, the U.S. Congress, the Securities andExchange Commission and the Financial Accounting Standards Board areconsidering changes to accounting rules concerning the recognition of stockoption compensation expense. If one or more of these proposals are implemented,we and other companies may be required to measure compensation expense usingthe fair value method, which would adversely affect our results of operationsby reducing our income or increasing our losses by an amount equal to suchstock option charges.

 

**Wehave a Limited Customer Base**

 

Two customers accounted for 39% and 35% of net sales for the threemonths ended October 31, 2003.  For thesame period in the prior year, those customers accounted for 10% and 15%,respectively, of net sales.  In addition,two customers that both accounted for less than 10% of net sales for the threemonths ended October 31, 2003, accounted for 46% and 14% of net sales for thesame period last year.  Four customersaccounted for 33%, 29%, 12% and 11% of net sales for the nine months endedOctober 31, 2003.  For the same periodin the prior year, those customers accounted for 20%, 21%, 20% and 20%,respectively, of net sales.  The Company expects that a smallnumber of customers will account for a substantial portion of its net sales forthe foreseeable future.  Furthermore,the majority of the Company’s sales was historically made, and is expected tocontinue to be made, on the basis of purchase orders rather than pursuant tolong-term purchase agreements.  As aresult, the Company’s business, financial condition and results of operationscould be materially adversely affected by the decision of a single customer tocease using the Company’s products, or by a decline in the number of handheldsystems sold by a single customer.

 

**WeMay Lose Our Customer Base**

 

The Company’s products aredesigned to afford the handheld systems manufacturer significant advantageswith respect to product performance, power consumption and size.  To the extent that other future developmentsin components or subassemblies incorporate one or more of the advantagesoffered by the Company’s products, the market demand for the Company’s productsmay be negatively impacted.

 

**WeFace Intense Competition in Our Markets**

 

Themarket for applications processors is intensely competitive and ischaracterized by rapid technological change, evolving industry standards anddeclining average selling prices. NeoMagic believes that the principal factors of competition in thismarket are imaging performance, price, features, power consumption, size andsoftware support.  The ability of theCompany to compete successfully in the applications processor market depends ona number of factors including, success in designing and subcontracting themanufacture of new products that implement new technologies, product qualityand

 

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reliability, price, ramp of production of theCompany’s products for particular system manufacturers, customer demand andacceptance of more sophisticated multimedia functionality on handheld systems,end-user acceptance of the system manufacturers’ products, market acceptance ofcompetitors’ products and general economic conditions.  The Company’s ability to compete in thefuture will also depend on its ability to identify and ensure compliance withevolving industry standards and market trends. Unanticipated changes in market trends and industry standards couldrender the Company’s products incompatible with products developed by majorhardware manufacturers and software developers. As a result, the Company couldbe required to invest significant time and resources to redesign its productsor obtain license rights to technologies owned by third parties in order toensure compliance with relevant industry standards and market trends.  There can be no assurance that the Companywill be able to redesign its products or obtain the necessary third-partylicenses within the appropriate window of market demand.  If the Company’s products are not incompliance with prevailing market trends and industry standards for asignificant period of time, the Company could miss crucial OEM/ODM designcycles, which could result in a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

NeoMagic competeswith both domestic and international companies, most of which havesubstantially greater financial and other resources than the Company with whichto pursue engineering, manufacturing, marketing and distribution of theirproducts.  The Company’s principalcompetitors include Intel’s StrongARM and XScale product lines, STMicroelectronic’s Nomadik line, certain of Samsung’s S3C chips, Nvidia’s Katanaline and Texas Instruments’ OMAP product line, as well as a number ofvertically integrated electronics firms who are developing their own solutions.  NeoMagic may also face increased competitionfrom new entrants into the handheld systems semiconductor market includingcompanies currently at developmental stages.

 

Some of the Company’s current and potential competitors operate theirown manufacturing facilities.  Since theCompany does not operate its own manufacturing facility and may fromtime-to-time make binding commitments to purchase products, it may not be ableto reduce its costs and cycle time or adjust its production to meet changingdemand as rapidly as companies that operate their own facilities, which couldhave a material adverse effect on the Company’s results of operations.

 

**OurProducts May be Incompatible with Evolving Industry Standards and Market Trends**

 

The Company’s ability to compete in the future will also depend on itsability to identify and ensure compliance with evolving industry standards andmarket trends.  Unanticipated changes inmarket trends and industry standards could render the Company’s productsincompatible with products developed by major hardware manufacturers andsoftware developers. As a result, the Company could be required to investsignificant time and resources to redesign its products or obtain licenserights to technologies owned by third parties in order to ensure compliancewith relevant industry standards and market trends.  There can be no assurance that the Company will be able toredesign its products or obtain the necessary third-party licenses within theappropriate window of market demand.  Ifthe Company’s products are not in compliance with prevailing market trends andindustry standards for a significant period of time, the Company could misscrucial OEM/ODM design cycles, which could result in a material adverse effecton the Company’s business, financial condition and results of operations.

 

**WeDepend on New Product Development to Meet Rapid Market and Technological Change**

 

The Company is focused on providing high-performance semiconductorsolutions for sale to original equipment manufacturers of handheld systems.  New product planning is primarily focused onIntegrated System-on-Chip semiconductor products for handheld systems, andmultimedia technologies for integration into such products, such as MPEG-4video compression, image processing, graphics, and audio technologies.  The Company’s future business, financialcondition and results of operations will depend to a

 

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significantextent on its ability to develop new products that address these market opportunities.As a result, the Company believes that significant expenditures for researchand development will continue to be required in the future.

 

The Company must anticipate the features andfunctionality that consumers and infrastructure providers will demand,incorporate those features and functionality into products that meet theexacting design requirements of equipment manufacturers, price its productscompetitively and introduce the products to the market on a timely basis. Thesuccess of new product introductions is dependent on several factors, includingproper new product definition, timely completion and introduction of newproduct designs, the ability to create or acquire intellectual property, theability of strategic manufacturing partners to effectively design and implementthe manufacture of new products, quality of new products, differentiation ofnew products from those of the Company’s competitors and market acceptance ofthe Company’s and its customers’ products. There can be no assurance that theproducts the Company expects to introduce will incorporate the features andfunctionality demanded by system manufacturers and consumers, will besuccessfully developed, or will be introduced within the appropriate window ofmarket demand, nor can there be assurance that customers who utilize theCompany’s semiconductor products will achieve the levels of market success withtheir own system products that they may project to the Company.

 

Because of the complexity of its products, the Companyhas experienced occasional delays in completing development and introduction ofnew products. In the event that there are delays in production of currentproducts, or in the completion of development of future products, including theproducts currently under development for introduction over the next 12 to 18months, the Company’s potential future business, financial condition, andresults of operations will be materially adversely affected.  In addition, the time required forcompetitors to develop and introduce competing products may be shorter,manufacturing yields may be better, and production costs may be lower thanthose experienced by the Company.

 

**WeDepend on Third-Party Manufacturers to Produce Our Products**

 

TheCompany’s products require wafers manufactured with state-of-the-artfabrication equipment and techniques. The Company currently utilizes severalfoundries for wafer fabrication. The Company expects that, for the foreseeablefuture, some of its products will be manufactured by a single source.  Since, in the Company’s experience, the leadtime needed to establish a strategic relationship with a new wafer fabricationpartner is at least 12 months, and the estimated time for a foundry to switchto a new product line ranges from four to nine months, there may be no readilyavailable alternative source of supply for specific products. A manufacturingdisruption experienced by the Company’s manufacturing partners, the failure ofthe Company’s manufacturing partners to dedicate adequate resources to the productionof the Company’s products, or the financial instability of the Company’smanufacturing partners would have a material adverse effect on the Company’sbusiness, financial condition and results of operations.  Furthermore, in the event that the transitionto the next generation of manufacturing technologies by the Company’smanufacturing partner is unsuccessful, the Company’s business, financialcondition and results of operations would be materially and adversely affected.

 

There are many other risks associated with theCompany’s dependence upon third-party manufacturers, including: reduced controlover delivery schedules, quality, manufacturing yields and cost; the potentiallack of adequate capacity during periods of excess demand; limited warrantieson wafers supplied to the Company; and potential misappropriation of NeoMagic’sintellectual property.  The Company isdependent on its manufacturing partners to produce wafers with acceptablequality and manufacturing yields, deliver those wafers on a timely basis to theCompany’s third party assembly subcontractors and to allocate to the Company aportion of their manufacturing capacity sufficient to meet the Company’sneeds.  Although the Company’s productsare designed using the process design rules of the particular manufacturer,there can be no assurance that the Company’s manufacturing partners will beable to achieve or maintain acceptable yields or deliver sufficient quantitiesof wafers on a timely basis or at an acceptable cost.  Additionally, there can be no assurance that the Company’smanufacturing partners will

 

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continue to devoteadequate resources to the production of the Company’s products or continue toadvance the process design technologies on which the manufacturing of theCompany’s products are based.

 

**We Rely on Third-Party Subcontractors toAssemble and Test Our Products**

 

The Company’sproducts are assembled and tested by third-party subcontractors. The Companydoes not have long-term agreements with any of these subcontractors. Suchassembly and testing is conducted on a purchase order basis.  As a result of its reliance on third-partysubcontractors to assemble and test its products, the Company cannot directlycontrol product delivery schedules, which could lead to product shortages orquality assurance problems that could increase the costs of assembling ortesting of the Company’s products.  Dueto the amount of time normally required to qualify assembly and testsubcontractors, product shipments could be delayed significantly if the Companywere required to find alternative subcontractors.  Any problems associated with the delivery, quality or cost of theassembly and test of the Company’s products could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

**WeMay Encounter Inventory Excess or Shortage**

 

The Company has wafer supply relationshipswith several foundries to support the Company’s product efforts.  Normally, the Company placesbinding purchase orders two to three months prior to wafer shipment.  The Company orders wafers for deliveries inadvance and with the additional time to assemble and test wafers, the Companycan have orders for finished goods that will not be available for up to fourmonths into the future. If the Company does not have sufficient demand for itsproducts and cannot cancel its current and future commitments without materialimpact, the Company may experience excess inventory, which will result in awrite-off affecting gross margin and results of operations.  If the Company cancels a purchase order, itmust pay cancellation penalties based on the status of work in process or theproximity of the cancellation to the delivery date.  The Company must place purchase orders for wafers before itreceives purchase orders from its own customers.  This limits the Company’s ability to react to fluctuations indemand for its products, which can be unexpected and dramatic, and fromtime-to-time will cause the Company to have an excess or shortage of wafers fora particular product.  As a result ofthe long lead-time for manufacturing wafers and the increase in “just in time”ordering by manufacturers, semiconductor companies such as the Company fromtime-to-time must take charges for excess inventory. The Company did in factincur such charges in fiscal 2001 of $9.2 million. Significant write-offs ofexcess inventory have had and could continue to have a material adverse effecton the Company’s financial condition and results of operations. Conversely,failure to order sufficient wafers would cause the Company to miss revenueopportunities and, if significant, could impact sales by the Company’scustomers, which could adversely affect the Company’s customer relationshipsand thereby materially adversely affect the Company’s business, financialcondition and results of operations.

 

**OurManufacturing Yields May Fluctuate**

 

The fabrication of semiconductors is an extremely complex process,which typically includes hundreds of process steps.  Minute levels of contaminants in the manufacturing environment,defects in masks used to print circuits on a wafer, utilization of equipmentwith variations and numerous other factors can cause a substantial percentageof wafers to be rejected or a significant number of die on each wafer to benonfunctional.  Many of these problemsare difficult to diagnose and time consuming or expensive to remedy.  As a result, semiconductor companies oftenexperience problems in achieving acceptable wafer manufacturing yields, whichare represented by the number of good die as a proportion of the total numberof die on any particular wafer.  TheCompany often purchases wafers, not die, and pays an agreed upon price forwafers meeting certain acceptance criteria. Accordingly, the Company bears the risk of the yield of good die fromwafers purchased meeting the acceptance criteria. The Company experienced suchyield problems in fiscal 2000, which materially adversely affected theCompany’s net sales, gross margins and results of operations in fiscal 2000 and2001.

 

Semiconductor manufacturing yields are a function ofboth product design, which is developed largely by the Company, and processtechnology, which is typically proprietary to the manufacturer.

 

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Historically, theCompany has experienced lower yields on new products.  Since low yields may result from either design or processtechnology failures, yield problems may not be effectively determined orresolved until an actual product exists that can be analyzed and tested toidentify process sensitivities relating to the design rules that are used.  As a result, yield problems may not beidentified until well into the production process, and resolution of yieldproblems would require cooperation by and communication between the Company andthe manufacturer.  This risk iscompounded by the offshore location of the Company’s manufacturers, increasingthe effort and time required identifying, communicating and resolvingmanufacturing yield problems.  As theCompany’s relationships with new manufacturing partners develop, yields couldbe adversely affected due to difficulties associated with adopting the Company’stechnology and product design to the proprietary process technology and designrules of each manufacturer.  Anysignificant decrease in manufacturing yields could result in an increase in theCompany’s per unit product cost and could force the Company to allocate itsavailable product supply among its customers, potentially adversely impactingcustomer relationships as well as revenues and gross margins.  There can be no assurance that the Company’smanufacturers will achieve or maintain acceptable manufacturing yields in thefuture.

 

**Uncertainty andLitigation Risk Associated with Patents and Protection of Proprietary Rights**

 

The Company relies in part on patents to protect its intellectualproperty. As of October 31, 2003, the Company has been issued 69 patents, eachcovering certain aspects of the design and architecture of the Company’sproducts.  Additionally, the Company hasnumerous patent applications pending. There can be no assurance that the Company’s pending patentapplications, or any future applications will be approved.  Further, there can be no assurance that anyissued patents will provide the Company with significant intellectual propertyprotection, competitive advantages, or will not be challenged by third parties,or that the patents of others will not have an adverse effect on the Company’sability to do business.  In addition,there can be no assurance that others will not independently develop similarproducts, duplicate the Company’s products or design around any patents thatmay be issued to the Company.

 

The Company alsorelies on a combination of mask work protection, trademarks, copyrights, tradesecret laws, employee and third-party nondisclosure agreements and licensingarrangements to protect its intellectual property.  Despite these efforts, there can be no assurance that others willnot independently develop substantially equivalent intellectual property orotherwise gain access to the Company’s trade secrets or intellectual property,or disclose such intellectual property or trade secrets, or that the Company canmeaningfully protect its intellectual property.  A failure by the Company to meaningfully protect its intellectualproperty could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

As ageneral matter, the semiconductor industry is characterized by substantiallitigation, regarding patent and other intellectual property rights.  In December 1998, the Company filed alawsuit in the United States District Court for the District of Delawareseeking damages and an injunction against Trident Microsystems, Inc.  The suit alleges that Trident’s embeddedDRAM graphics accelerators infringe certain patents held by the Company.  In January 1999, Trident filed a counterclaim against the Company alleging an attempted monopolization in violation ofantitrust laws, arising from NeoMagic’s filing of the patent infringementaction against Trident. The Court ruled that there was no infringement byTrident. The Company filed an appeal in the United States Court of Appeals, forthe Federal Circuit.  On April 17, 2002,the United States Court of Appeals for the Federal Circuit affirmed the lowercourt’s judgment of non-infringement on one patent and vacated the court’sjudgment of non-infringement on another patent, thereby remanding it to thelower court for further proceedings. In November 2002, the lower court heardoral arguments on cross-motions for summary judgment on the matter.  In May 2003, the lower court ruled in favorof Trident. In August 2003 the Company started the process to file an appeal inthe United States Court of Appeals, for the Federal Circuit.  Management believes the Company has validdefenses against Trident’s claims. There can be no assurance as to the resultsof the patent infringement appeal and the counter-suit for antitrust filed byTrident.

 

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Any patent litigation, whether or not determined in the Company’s favoror settled by the Company, would at a minimum be costly and could divert theefforts and attention of the Company’s management and technical personnel fromproductive tasks, which could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.  There can be no assurance that current orfuture infringement claims by third parties or claims for indemnification byother customers or end users of the Company’s products resulting frominfringement claims will not be asserted in the future or that such assertions,if proven to be true, will not materially adversely affect the Company’sbusiness, financial condition and results of operations.  In the event of any adverse ruling in anysuch matter, the Company could be required to pay substantial damages, whichcould include treble damages, cease the manufacturing, use and sale ofinfringing products, discontinue the use of certain processes, or to obtain alicense under the intellectual property rights of the third party claiminginfringement.  There can be noassurance, however, that a license would be available on reasonable terms or atall.  Any limitations on the Company’sability to market its products, or delays and costs associated with redesigningits products or payments of license fees to third parties, or any failure bythe Company to develop or license a substitute technology on commerciallyreasonable terms could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

**WeDepend on International Sales and Suppliers**

 

Export sales have been a critical part of the Company’s business.  Sales to customers located outside theUnited States (including sales to the foreign operations of customers withheadquarters in the United States and foreign system manufacturers that sell toUnited States-based OEMs) accounted for 91% and 90% of net sales in the threemonths ended October 31, 2003 and 2002, respectively.  Export sales accounted for 88% and 89% of net sales in the ninemonths ended October 31, 2003 and 2002, respectively.  The Company expects that net sales derived from internationalsales will continue to represent a significant portion of its total netsales.  Letters of credit issued bycustomers have supported a portion of the Company’s international sales.  To date, the Company’s international saleshave been denominated in United States dollars.  Increases in the value of the U.S. dollar relative to the localcurrency of the Company’s customers could make the Company’s productsrelatively more expensive than competitors’ products sold in the customer’slocal currency.

 

International manufacturers have produced,and are expected to continue to produce for the foreseeable future, all of theCompany’s wafers.  In addition, many ofthe assembly and test services used by the Company are procured frominternational sources.  Wafers arepriced in U.S. dollars under the Company’s purchase orders with itsmanufacturing suppliers.

 

International sales and manufacturing operations are subject to avariety of risks, including fluctuations in currency exchange rates, tariffs,import restrictions and other trade barriers, unexpected changes in regulatoryrequirements, longer accounts receivable payment cycles, potentially adversetax consequences and export license requirements.  In addition, the Company is subject to the risks inherent inconducting business internationally including foreign government regulation,political and economic instability, and unexpected changes in diplomatic andtrade relationships.  Moreover, the lawsof certain foreign countries in which the Company’s products may be developed,manufactured or sold, may not protect the Company’s intellectual propertyrights to the same extent as do the laws of the United States, thus increasingthe possibility of piracy of the Company’s products and intellectualproperty.  There can be no assurancethat one or more of these risks will not have a material adverse effect on theCompany’s business, financial condition and results of operations.

 

**WeMay Need Additional Capital**

 

The Companyrequires substantial working capital to fund its business, particularly tofinance inventories and accounts receivable and for capital expenditures.  The Company believes that its existingcapital resources will be sufficient to meet the Company’s capital requirementsthrough the next 12 months, although the Company could be required, or couldelect, to seek to raise additional capital in the future.  The Company’s future capital requirementswill depend on many factors, including the rate of net sales growth, timing andextent of spending to support research and development programs in new andexisting

 

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areas of technology, expansionof sales and marketing support activities, and timing and customer acceptanceof new products. The Company may raise additional equity or debt financing inthe future.  There can be no assurancethat additional equity or debt financing, if required, will be available onacceptable terms or at all.

 

**Weare Dependent on Qualified Personnel**

 

The Company’s future success depends in part on the continued serviceof its key engineering, sales, marketing, manufacturing, finance and executivepersonnel, and its ability to identify, hire and retain additional personnel.  There is strong competition for qualifiedpersonnel in the semiconductor industry, and there can be no assurance that theCompany will be able to continue to attract and retain qualified personnelnecessary for the development of its business. The Company has experienced the loss of certain key personnel and alsoreduced personnel in its restructuring. If the Company’s headcount is not appropriate for its future directionand the Company fails to recruit key personnel critical to its future directionin a timely manner, it may have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

**Our Stock Price MayBe Volatile**

 

The market price of the Company’s Common Stock, like that of othersemiconductor companies, has been and is likely to continue to be, highlyvolatile.  The market has fromtime-to-time experienced significant price and volume fluctuations that may beunrelated to the operating performance of particular companies.  The market price of the Company’s CommonStock could be subject to significant fluctuations in response to variousfactors, including quarter-to-quarter variations in the Company’s anticipatedor actual operating results, announcements of new products, technologicalinnovations or setbacks by the Company or its competitors, general conditionsin the semiconductor industry, unanticipated shifts in the handheld systemsmarket or industry standards, loss of key customers, litigation commencement ordevelopments, changes in or the failure by the Company to meet estimates of theCompany’s performance by securities analysts, market conditions for hightechnology stocks in general, and other events or factors.  In future quarters, the Company’s operatingresults may be below the expectations of public market analysts or investors.  Since the Company’s decline in revenues,gross margins and operating results, the market price of the Common Stock hasbeen and is expected to be for some time in the future, materially adverselyaffected.

 

There may notbe an active, liquid trading market for our common stock. For several weeks inOctober 2002, our common stock traded below the $1 minimum bid pricerequirement of the NASDAQ National Market. If we fail to comply with thecontinued listing requirements of the NASDAQ National Market, including theminimum bid price per share requirement, we may be delisted from trading onsuch market, and thereafter trading in our common stock, if any, would beconducted through the NASDAQ Small Cap Market, the over-the-counter market oron the Electronic Bulletin Board of the National Association of SecuritiesDealers, Inc. There is no guarantee that an active trading market for ourcommon stock will be maintained on the NASDAQ National Market. You may not beable to sell your shares quickly, at the market price or at all if trading inour stock is not active.

 

**Item 3****.   Quantitative and Qualitative Disclosuresabout Market Risk**

 

# **InterestRate Risk**

 

The Company’scash equivalents, short-term investments, and long-term investments are exposedto financial market risk due to fluctuations in interest rates, which mayaffect our interest income.  As ofOctober 31, 2003, the Company’s cash equivalents and short-term investmentsearned interest at an average rate of 1.2%. Due to the short-term nature of the Company’s investment portfolio,operating results or cash flows are vulnerable to sudden changes in marketinterest rates.  Assuming a decline of10% in the market interest rates at October 31, 2003, with consistent cashbalances,

 

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interest income would beadversely affected by approximately $14,000 per quarter.  The Company does not use its investmentportfolio for trading or other speculative purposes.

 

# **ForeignCurrency Exchange Risk**

 

Currently all ofthe Company’s sales and the majority of its expenses are denominated in U.S.dollars.  As a result, the Company hasrelatively little exposure to foreign currency exchange rate risk.  The Company does not currently enter intoforward exchange contracts to hedge exposures denominated in foreign currenciesor any other derivative financial instruments for trading or speculativepurposes.  However, in the eventexposure to foreign currency risk increases, the Company may choose to hedgethose exposures.

 

**Item 4****.   Disclosure Controls and Procedures**

 

**Evaluation ofDisclosure Controls and Procedures**

 

The Company’s management, with the participation ofthe Company’s Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of the Company’s disclosure controls and procedures(as such term is defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended  (the“Exchange Act”)) as of the end of the period covered by this report.  Based on such evaluation, the Company’sChief Executive Officer and Chief Financial Officer have concluded that, as ofthe end of such period, the Company’s disclosure controls and procedures areeffective in recording, processing, summarizing and reporting, on a timelybasis, information required to be disclosed by the Company in the reports thatit files or submits under the Exchange Act.

 

**Changes in InternalControls Over Financial Reporting**

 

During the third quarter of fiscal 2004, theCompany took steps to strengthen its controls over stock administration byadding a stock administration specialist.

 

Other than as noted above, there were nochanges in the Company’s internal controls over financial reporting thatoccurred during the period covered by this report that has materially affected,or is reasonably likely to materially affect, our internal controls overfinancial reporting.

 

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**Part II****.  Other Information**

 

***Item 1***.   Legal Proceedings

 

As a general matter, the semiconductor industry is characterized bysubstantial litigation, regarding patent and other intellectual propertyrights.  In December 1998, the Companyfiled a lawsuit in the United States District Court for the District ofDelaware seeking damages and an injunction against Trident Microsystems,Inc.  The suit alleges that Trident’sembedded DRAM graphics accelerators infringe certain patents held by theCompany.  In January 1999, Trident fileda counter claim against the Company alleging an attempted monopolization inviolation of antitrust laws, arising from NeoMagic’s filing of the patentinfringement action against Trident. The Court ruled that there was noinfringement by Trident. The Company filed an appeal in the United States Courtof Appeals, for the Federal Circuit.  OnApril 17, 2002, the United States Court of Appeals for the Federal Circuitaffirmed the lower court’s judgment of non-infringement on one patent andvacated the court’s judgment of non-infringement on another patent, therebyremanding it to the lower court for further proceedings. In November 2002, thelower court heard oral arguments on cross-motions for summary judgment on thematter.  In May 2003, the lower courtruled in favor of Trident. In August 2003 the Company started the process tofile an appeal in the United States Court of Appeals, for the FederalCircuit.  Management believes theCompany has valid defenses against Trident’s claims. There can be no assuranceas to the results of the patent infringement appeal and the counter-suit forantitrust filed by Trident.

 

***Item 2.***   Changes inSecurities

None.

 

***Item 3.***   Defaults UponSenior Securities

None.

 

***Item 4.***   Submission ofMatters to a Vote of Security Holders

None

 

***Item 5.***   Other Information

Notapplicable.

 

***Item 6.  ***Exhibits and Reports on Form 8-K

(a)          Exhibits

The exhibits listed in the accompanying Exhibit Index on page 31 arefiled or incorporated by reference as part of this Report on Form 10-Q.

 

(b)         Reports on Form 8-K

On August 14, 2003, the Company filed a report on Form8-K reporting the financial results for the quarter ending July 31, 2003.

 

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#### **SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   | NEOMAGIC CORPORATION           |                 |
|--------|--------------------------------|----------------------|
|   | (Registrant)                   |                 |
|   |                           |                 |
|   |                           |                 |
|   |                           | /s/ Stephen T. Lanza |   |   |
|   | **STEPHEN T. LANZA**           |                 |
|   | Acting Chief Financial Officer |                 |
|   |                           |                 |
|   |                           | /s/ M.J. Silva       |   |   |
|   | **M.J. SILVA**                 |                 |
|   | Principal Accounting Officer   |                 |
|   |                           |                 |
|   | December 10, 2003              |                 |
|   |                           |                 |

 

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**EXHIBITINDEX**

 

The following Exhibits are filed as part of, or incorporated byreference into, this Report:

** **
| **Number** |   | **Description** |
|------------|--------|-----------------|
|       |   |            |   |   |
| 3.1        |   | (1)             |   | Amended and Restated Certificate of Incorporation. |
| 3.2        |   | (1)             |   | Bylaws. |
| 3.3        |   | (9)             |   | Certificate of Designation of Rights, Preferences and Privileges of  Series A Participating Preferred Stock. |
| 4.1        |   | (10)            |   | Preferred Stock Rights Agreement dated December 19, 2002, between the  Company and EquiServe Trust Company, N.A. |
| 10.1       |   | (1)             |   | Form of Indemnification Agreement entered into by the Company with  each of its directors and executive officers. |
| 10.2       |   | (2)             |   | Lease Agreement, dated as of October 9, 1997, between the Company and  A&P Family Investments, as landlord for the leased premises located at  3250 Jay Street. |
| 10.3       |   | (1)             |   | Amended and Restated 1993 Stock Plan and related agreements. |
| 10.4       |   | (2)             |   | Amendment No. 1, dated as of October 15, 1997, between the Company  and A&P Family Investments, as landlord for the leased premises located  at 3260 Jay Street. |
| 10.5       |   | (1)             |   | Lease Agreement, dated as of February 5, 1996, between the Company  and A&P Family Investments, as landlord. |
| 10.6       |   | (1)             |   | 1997 Employee Stock Purchase Plan, with exhibit. |
| 10.7       |   | (4)             |   | 1998 Nonstatutory Stock Option Plan. |
| 10.8       |   | (4)             |   | Wafer Supply Agreement, dated as of March 15, 1999, between NeoMagic  International Corporation and Siemens Aktiengesellschaft Semiconductor Group,  now Infineon Technologies AG. |
| 10.9       |   | (5)             |   | General Amendment to the Wafer Supply Agreement with Product Sourcing  Agreement, dated January 9, 2001, between NeoMagic International Corporation  and Infineon Technologies AG. |
| 10.10      |   | (6)             |   | Employment Offer Letter dated May 10, 2000, between the Company and  Sanjay Adkar. |
| 10.11      |   | (6)             |   | Employee Loan Agreement dated May 10, 2000, between the Company and  Sanjay Adkar. |
| 10.12      |   | (6)             |   | Security Agreement dated September 1, 2001, between the Company and  Stephen Lanza. |
| 10.13      |   | (6)             |   | Promissory Note dated September 1, 2001, between the Company and Stephen  Lanza. |
| 10.14      |   | (7)             |   | Full and Final Release dated September 9, 2002, from the Wafer Supply  Agreement and the Product Sourcing Agreement between NeoMagic International  Corporation and Infineon Technologies AG. |
| 10.15      |   | (8)             |   | Amendment No. 1, dated as of February 26, 2002, between the Company  and A&P Family Investments, as landlord for the leased premises located  at 3250 Jay Street. |
| 10.16      |   | (8)             |   | Amendment No. 2, dated as of April 7, 2000, between the Company and  A&P Family Investments, as landlord for the leased premises located at  3260 Jay Street. |
| 10.17      |   | (8)             |   | Amendment No. 3, dated as of February 26, 2002, between the Company  and A&P Family Investments, as landlord for the leased premises located  at 3260 Jay Street. |
| 10.18      |   | (11)            |   | Amendment No. 4, dated as of January 31, 2003, between the Company  and A&P Family Investments, as landlord for the leased premises located  at 3260 Jay Street. |
| 31.1       |   |            |   | Certification of the Chief Executive Officer pursuant to Securities  Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002 dated December 10, 2003. |
| 31.2       |   |            |   | Certification of the Chief Financial Officer pursuant to Securities  Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002 dated December 10, 2003. |
| 32.1       |   |            |   | Certification by the Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as |

 

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|   |   |   |   | adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                       |
|--------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| 32.2   |   |   |   | Certification by the Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

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(1)          Incorporated by reference to the Company’sregistration statement on Form S-1, registration no. 333-20031.

(2)          Incorporated by reference to the Company’sForm 10-Q for the period ended October 31, 1997.

(3)          Incorporated by reference to the Company’sForm 10-K for the year ended January 31, 1998.

(4)          Incorporated by reference to the Company’s Form10-K for the year ended January 31, 1999.

(5)          Incorporated by reference to the Company’sForm 10-K for the year ended January 31, 2001.

(6)          Incorporated by reference to the Company’sForm 10-K for the year ended January 31, 2002.

(7)          Incorporated by reference to the Company’sForm 10-Q for the quarter ended July 31, 2002.

(8)          Incorporated by reference to the Company’sForm 10-Q for the quarter ended October 31, 2002.

(9)          Incorporated by reference to the Company’sForm 8-A filed December 23, 2002.

(10)    Incorporated by reference to the Company’s Form 8-Kfiled December 23, 2002.

(11)    Incorporated by reference to the Company’s Form10-K for the year ended January 31, 2003.

 

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